Author:  Lori Alden

 

Why are some firms more profitable than others?  

            A firm's profitability depends on more than just how well it's run.  Some well-managed firms make very low profits, while some poorly-managed firms make very large profits.  

            A firm's profitability depends in part on whether other firms can easily enter its market and compete with it.  When other firms are free to enter a market, economic profits tend to very low, even for well-managed firms.  When firms are prevented from entering a market, economic profits can be quite high.  

            Economic profits are the difference between a firm's revenue and opportunity cost.  A firm doesn't need to earn any economic profits at all to be willing to stay in business.  Such a firm would still be covering all its opportunity costs, or doing just as well as it could if it used its resources in their best alternative use.  

            Economic profits, then, are like gravy for a firm, more than enough to keep it in business.  As such, they serve as a powerful incentive to enter a market, luring entrepreneurs who are hungry for opportunities to make money.    

            But as new firms enter markets in search of economic profits, existing firms are forced to compete by lowering their prices and making do with fewer customers.  This eats into the economic profits of all firms in the market.  It's only after these profits have been almost completely devoured that the process of entry stops.  Hungry entrepreneurs will then pass over the now unprofitable market in search of new opportunities.  

            For example, when video rental stores first started popping up in the early 1980s, many of them made a lot of money.  Other people quickly caught on that this was a profitable opportunity, and opened their own stores.  By the late 1980s, video stores seemed to be everywhere, competing desperately for customers with low prices and speedy service.  Now that the economic profits have been squeezed out of most video rental stores, entry by new firms has slowed to a trickle.  

            As long as new firms are free to enter a market, they will drive down economic profits.  Yet in many markets, firms continue to enjoy large economic profits year after year.  Something must be preventing eager new firms from entering these markets.  

            New firms can be prevented from entering product markets by barriers to entry.  Barriers to entry are advantages that existing firms have over new firms wishing to enter a market.  What are these advantages?

 

  • Patents and Copyrights  

            When inventors or firms develop new products, they can apply for patents.  A patent prohibits others from selling a product for a period of seventeen years.  By insulating inventors from competition, patents enable them to charge higher prices and make large economic profits.  Patents foster new inventions by rewarding inventors for the expense and risk of bringing a new product to market.  

            In the same way, writers, artists, and musicians can copyright their work.  Copyrights give their holders the exclusive right to reproduce things like books, plays, software, films, songs, and paintings.  As with patents, this rewards the copyright holder by protecting her or him from competition.  

 

  • Government Barriers to Entry

             Federal, state, and local governments sometimes restrict entry into markets by requiring firms to have licenses.  The Federal Communications Commission, for example, grants licenses to radio and television stations; there simply aren't enough frequencies for an unlimited number of firms to broadcast in any area.   For safety reasons, all nuclear power plants are licensed as well.   

            Governments also bar entry by giving firms exclusive rights to a market.  The U.S. Postal Service, for example, has an exclusive right to deliver first class mail.  Firms are sometimes given exclusive rights to do things like operate gas stations along toll roads, produce electricity, or collect garbage in a city.  Exclusive rights are granted if a government believes that there is room for only one firm in a market.  

            Until the 1980s, the federal government also restricted entry into the airline, trucking, banking, and telecommunications industries.  Many of the laws that restricted entry into these industries were put into place in the 1930s, when many people believed that large firms needed to be protected from "cutthroat competitors."  Many economists now believe that these laws did more harm than good.  

            In 1938, for example, the Civil Aeronautics Board, or CAB, was established to regulate the airline industry for interstate flights.  For the forty years that it existed, it didn't allow a single new firm to enter the market, although it received over 150 applications for routes.  In 1978, despite protests from the airlines, President Carter ordered the deregulation of the industry and the phasing out of the CAB.  Within five years, 14 new firms entered the industry.  Many experts believe that airline fares after deregulation were well below what they would have been had regulation continued.           

 

  • Economies of scale  

            Often a large firm can produce a good at a lower unit cost than a small firm.  The Oakdale Foods Corporation, for example, can produce a jar of strawberry jam for much less than Mrs. Montoya, who produces a hundred jars a year for her family and friends.  Unlike Mrs. Montoya, Oakdale Foods buys its glassware, sugar, strawberries, labels, and pectin wholesale, and gets quantity discounts.  Oakdale Foods also uses large, labor-saving equipment to cut costs; since Mrs. Montoya makes jam only once a year, it doesn't make sense for her to buy a lot of specialized equipment.  Oakdale Foods also has highly trained and specialized workers; Mrs. Montoya has to consult the jam recipe from time to time.  

            When a firm can cut unit costs by expanding its size, or "scale," we say that it is experiencing economies of scale.  Because of economies of scale, huge factories are usually built to produce goods like automobiles, computer chips, and refrigerators.  If you wanted to go into business producing any of these goods, you would need to spend millions of dollars to build a factory large enough to enable you to compete effectively.  Since most of us don't haveand can't borrowthat much money, we are prevented from competing in those markets.

 

  • Control of Raw Materials  

            Sometimes firms are prevented from entering a market because they can't obtain a resource critical to production.  For example, Alcoa Aluminum used to have control over the world's supply of bauxite, which is used in producing aluminum.  Without bauxite, other firms were unable to produce aluminum, and Alcoa had the market to itself.

 

  • Advertising  

            Anacin once advertised that it's "strongest in the pain reliever doctors recommend most," and that it contains "what 2 out of 3 doctors call the greatest pain fighter ever discovered."  What is this miracle pain reliever?  It's acetylsalicylic acid, more commonly known as aspirin.  

            Most of the aspirin consumed in the United States is produced by two firms, Dow and Monsanto.  These firms sell the aspirin in powdered form to drug companies, which add inactive ingredients like cornstarch to it, then press the mixture into tablets.  The tablets are then sold in retail stores under hundreds of different labels.  

            Even though all aspirin is virtually the same, prices vary enormously.  Heavily advertised brands like Anacin and Bayer are up to six times as expensive as unadvertised store brands.  Yet the more expensive brands are bought by millions of consumers each year.  This may be due in part to misleading advertising; Bayer, for example, used to claim that "[a]spirin is the best pain reliever and Bayer is the best aspirin."  A federal judge later ordered the advertisements stopped when Bayer was unable to prove that it was indeed the best aspirin.  

            Advertising is designed to make consumers loyal to certain brands, like Bayer, Coke, Snickers, and Calvin Klein.  If this "brand loyalty" is strong enough, it can act as a big barrier to entry.  In order to launch a new product on the national market, for example, firms sometimes spend over $100 million on advertising in order to coax consumers away from their favorite brands.  Since eight out of ten of these attempts fail anyway, few of us can put together the necessary resources to enter markets in which firms advertise extensively.  

 

  • Protection from Foreign Competitors  

            American firms aren't the only ones hungry for economic profits; foreign firms wish to compete in our markets as well.  Domestic firms often try to impede the entry of foreign firms by asking Congress for protection from foreign competition.  Protection usually comes in two forms:  taxes on foreign imports, which make them more expensive compared with domestic goods, and quotas on the number of foreign goods that can be imported.  

            If domestic firms can be protected from competition with foreign firms, they're able to charge higher prices for their goods.  Protection, then, is in the interest of the firms seeking it, but not in the interest of their consumers.   

 

Market Structure           

            Economists classify markets according to how much market power is exercised by the firms in them.  At one extreme are markets with few barriers to entry.  These markets usually have many firms, each with very little market power.  At the other extreme are markets with such large barriers to entry that only one firm exists.  Such firms have the potential to wield enormous market power.

 

  • Competition  

            Many markets have few barriers to entry, and lots of small firms invariably spring up.  It doesn't take a lot of money to open a small business like a Drive-In, restaurant, hardware store, clothing factory, or barbershop, and millions of people have started these kinds of firms in their quest for economic profits.  These kinds of markets are relatively competitive, or free from the use of market power.   

            It's hard, though, for a business to make large economic profits in a competitive market.  A restaurant, for example, can't increase its prices by much without losing customers to other restaurants.  And if a restaurant is lucky enough to do well, people take notice and open others nearby.  Even well-managed restaurants are often doomed to low economic profits.  

            Brutal as these markets are to the firms in them, competitive markets are the favorites of economists.  Since the rigors of competition weed out firms that are poorly managed, competitive firms are strongly motivated to find ways to cut costs.  Lower costs and lower economic profits mean lower prices for consumers.  Best of all, economists have found that these markets are very efficient at allocating resources. 

            Among the most competitive markets of all are those for agricultural goods.  There are tens of thousands of wheat producers, for example, and none of them has any market power whatsoever.  In fact, wheat farmers don't even need to think about what price to charge; the price of wheat is determined by supply and demand, and farmers simply look up the price they will get for their crops in the financial section of their newspapers.  

 

  • Oligopoly  

            The word "oligopoly" comes from two Greek words:  oligo, meaning "few," and polein, "sellers."  An oligopoly, then, is a market dominated by a few sellers.  The automobile, tire, cigarette, airline, and steel industries are examples of oligopolies.

            Many seemingly competitive markets are in fact oligopolistic.  For example, Tide, Dash, Dreft, Ivory Snow, Bold, Oxydol, Cheer, and Gain detergents are all produced by a single firm, Procter and Gamble, and most of the other detergents on supermarket shelves are produced by just two other firms, Colgate-Palmolive and Lever Brothers.  

            The dominant firms in an oligopolistic market often have large factories, huge advertising budgets, patented products, and control over raw materials.  These barriers to entry make it very hard for new or smaller firms to compete with them.  

            Since oligopolies are insulated from competition, they are able to exercise market power and raise their prices above what they would be in a more competitive market.  But they have to be careful.  Since there are other producers in the market, a firm that raises its price too much may lose some of its customers to rivals.  

            Of course, a firm can raise prices and keep most of its customers if all the other firms in the market also raise their prices.  That's why there is such a strong temptation for firms to collude, or agree not to compete.  Collusion is illegal in the United States , and corporations that are convicted of colluding are fined and their executives sometimes sent to jail.  

            Whether or not they collude, oligopolies often earn substantial economic profits.  This isn't necessarily a result of shrewd management; sheltered as they are from the stern discipline of competition, even mismanaged oligopolies can make good profits.  Because of this, many economists wonder if oligopolies are as diligent about cutting costs as competitive firms.  

            What also bothers economists is that oligopolies are inefficient at allocating resources.  Market power enables oligopolies to charge prices that are well above their marginal costs of production.  As we'll see in a moment, this means that worthwhile trades are not being made in these markets, trades that would benefit both parties.  Nothing riles economists more than to see an opportunity to make a worthwhile trade go unexploited.  

            The price of Sheila's favorite soft drink, for example, is 40 cents per can, but the marginal cost of producing it is only 10 cents.  Sheila consumes only one soda a day; the marginal benefit to her of a second can is only 30 cents, so she doesn't buy it.  And here's where an opportunity for a worthwhile exchange arises.  If the soda firm sold Sheila a second can for, say, 25 cents, both of them would come out ahead.  The firm would end up selling a soda for 15 cents more than it cost to produce, while Sheila would end up paying 25 cents for a soda that gives her 30 cents worth of benefits. 

 

            The soda firm would never go ahead with this deal, of course.  If it charged Sheila a lower price for a soda, then all its other customers would demand lower prices too, and the firm's profits would be threatened.  Unfortunately, preserving the profits of oligopolists in this way is costly to society.  Economists believe that oligopolistic markets thwart billions of dollars of worthwhile trades each year.  

            Since the cost to society from market power is so high, our government strives constantly to increase competition in oligopolistic markets.  The Federal Trade Commission and the Justice Department enforce antitrust laws, or laws designed to foster competition.  Antitrust laws prohibit collusion, and also forbid mergers that greatly reduce competition.  A merger occurs when one firm buys the assets of another firm in order to make one large firm.

 

  • Monopoly  

            Mono is Greek for "one," and a monopoly is a market in which there is only one seller.  The markets for electricity, Polaroid cameras, local telephone service, and postage stamps are all monopolistic.   

            As the only seller in a market, a monopoly has the ability to wield enormous market power.  With this market power, a monopoly can set its price well above the marginal cost of production.  This enables the firm to earn large economic profits, but it's inefficient.  As we saw with oligopolies, setting the price above the marginal cost of production prevents worthwhile trades from taking place.   

            In spite of this, the government often allows monopolies to exist.  Thanks to economies of scale, a monopoly can often produce output much more cheaply than several smaller firms can.  For example, it's cheaper to build a single 1,000-megawatt nuclear power plant than two 500-megawatt plants.  And allowing just one firm to provide a service to all customers in an area can sometimes avoid duplication of effort.  It wouldn't make sense to have several mail carriers delivering letters to each house, or several bus firms covering the same route.  

            To protect consumers, governments often try to control the market power of monopolies.  One way to do this is is through regulation.  A regulatory agency typically will give a privately-owned firm exclusive rights to a market, but regulate the firm's prices and standards of service.  The agency usually sets the price so as to give the firm a modest profit.   

            Regulating a monopoly's profit prevents it from exploiting its market power, but it causes other problems.  Most firms are eager to cut costs so that they can earn more profits.  But if a regulated monopoly succeeds in cutting costs, its regulatory agency will often take away any excess profits that it makes by forcing the firm to lower its price.   This means, of course, that regulated monopolies don't have much incentive to cut their costs.  To correct for this, regulatory agencies often monitor their operations carefully to make sure that they're being well managed.  

            A second way to control the market power of monopolies is through nationalization, in which the government owns and operates the monopoly.  Examples of nationalized monopolies in the United States include the U.S. Postal Service, most municipal transportation systems, and the Tennessee Valley Authority, which supplies electricity to several southeastern states.  

            Like regulated private monopolies, nationalized monopolies lack the incentive of profits to spur them to cut costs.  Nationalized monopolies turn any profits they earn over to the government; if they lose money, taxpayers make up the difference.  

            When a monopoly is the result of a patent or copyright, the government usually allows the firm to charge whatever it wants for its product despite the inefficiency that results.  Fortunately, these firms are still under some pressure to keep prices down.  Take Paramount , which has an exclusive right to sell DVDs of the movie The Longest Yard.  It knows that if it charges too much, consumers will simply buy other movies, or not buy any movies at all.  Even so, Paramount charges higher prices than it would in more competitive markets. 

           

          

 

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